“Severe economic recessions often feature what might be called an ‘incubation phase,’ where an exuberant rebound from initial stock market losses becomes detached from the quiet underlying deterioration of economic fundamentals and corporate balance sheets.” Dr. John Hussman
Markets ended 2019 with hope and promise that 2020 would bring more of the same, gains for stocks and a growing US economy that had achieved the lowest level of unemployment in history. However, the reality of what we have experienced as a country and a world thus far in 2020 is anything but the high hopes that rang in the New Year. Instead, we have been gripped by a global pandemic that began in the Wuhan province of China and spread around the world.
In the US, we have seen over 100,000 people lose their lives, and millions of people filed for unemployment as businesses large and small were put under strict lockdown orders from local, state, and federal government.
Subsequently, we saw the Dow plunge, from a high of nearly 30,000 to a low just below 18,000. This 40% drop in the equity markets was then followed by an equally ferocious rip higher, as the markets digested a seemingly unlimited supply of Fed liquidity. The market has steadily moved higher until last Thursday’s nearly 7% drop. The volatility we are seeing in the market is concerning, leaving many investors to wonder what they should do with their hard-earned dollars.
When I first began writing about Treasury bonds at the end of 2014, the notion of owning a Treasury over equities was widely criticized assuring investors that there would be a large equity risk premium waiting for them in choosing the S&P 500 index over the Treasury. During that period, an investor in the Vanguard Extended Duration Treasury Index (MUTF:VEDTX), a proxy for 30-year Zero Coupon US Treasury Securities, would have outpaced an investment in the Vanguard S&P 500 Index (MUTF:VFIAX).
That’s right, no equity risk premium in that entire period despite massive rips for the equity market. Markets tend to take the escalator up and the elevator down, and that is exactly what we have seen of late, and I believe we will see more of as we move through 2020. Despite the near deafening calls of the “don’t fight the Fed” crowd, I believe the best asset to own in this environment is the 30-year Zero Coupon US Treasury. This is the result of a multitude of risks ranging from the continued impact on consumer income, and spending behavior, to political risk, to a rising left tail risks.
A Multitude of Risks are Rising
Market Valuation & Material Impact of Earnings Impairment
We are in a depression. I know it may not feel like one, but we are, and the data confirms it. Unemployment remains elevated with a U-6 measure of 21.6% showing severe damage to the labor market and to corporate earnings.
The question remains will consumers return to their normal behavior as the street contends in this “V” shaped recovery thesis? I do not believe this to be the case. The severe economic and psychological damage done I believe will be felt for years to come. The depression generation carried those scars with them through the rest of their lives, and I don’t believe this will be any different.
The fear of economists is that we fall into a deflationary trap, where consumers are reluctant to spend, thus businesses lower prices in order to entice them to spend, leading consumers to question why spend today, when it will be cheaper tomorrow, and around and around we go. This deflationary spiral is the fear of policy makers, and rightfully so. Deflation is incredibly devastating, and very difficult to get out of.
Markets Remain Severely Overvalued
Markets continue to be massively overvalued against the historical mean, leading market participants to wonder if we have a material impairment to corporate earnings, consumer income, and consumer spending behavior, then how will these companies be able to generate the earnings they did pre-crisis? The answer is they likely cannot. Add on to this the continued debt burdens on consumers and the lack of political will for additional stimulus, or the continuation of programs meant to help the consumer like student loan payment moratoriums, and you are talking about severe downward pressure on disposable income for consumers to spend in the economy.
Rising Covid-19 Infection Rate
Additional risk is the rising infection rate for Covid-19. While the curve seemed to have flattened, we are now seeing a spike in cases in Texas, Arizona, Oregon and many other parts of the country. I expect this continued wave of infections to continue making reopening a lumpy process, creating continued risk for small businesses already hurt by the shutdowns.
Rising Political Risk
We are also in an election year, where there is a material economic threat to this market. If Democrats should sweep, the GOP led tax cuts which have benefited corporations and corporate earnings would likely be reversed, creating a material impact on corporations’ ability to invest and weather the storm that may lie ahead. This would obviously cause a major repricing to the equity market to the downside to reflect this new information. In addition, there is a rising tension between the world’s two most important economies, the US and China. Continued rhetoric could mean a material impact on the phase 1 trade deal with China, and the threat of further economic impact on the US.
While many continue to put their chips on a continued “V” recovery, the reality seems much different. Recent data showing that jobless claims were worse than expected is only the tip of the iceberg of bad data to follow. The Covid-19 crisis has had far reaching effects that I do not believe will be going away anytime soon. This deep damage to the US economy could take a decade to climb out of.
At already expensive levels, US equities represent negative total returns for investors looking out over the next decade, where we will likely face the continuing severe damage of a deflationary debt storm that will grind US GDP to a halt. The current market rise is nothing but a bear market rally creating a great deal of risk for US equity holders. The 30-year US Treasury on the other hand, providing a positive yield in a negative yield world, will be a flight to safety as we continue to grind through this period of time, and process the lasting negative economic effects of Covid-19 amidst the backdrop of a severely indebted economy that will put downward pressure on GDP growth, pushing Treasury yields at the long end of the curve down.
The greatest risk the economy faces right now is deflation risk. Deflation risk continues to put pressure on the US economy pushing inflationary expectations down, and creating an opportunity for investors in 30-year Zero Coupon US Treasury Bonds, as a port in the coming deflationary storm.
Disclosure: I am/we are long US TREASURY BONDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.